Japan's Deflation: A Time-Inconsistent Policy in Need of an Inflation Target*

Thomas F. Cargill and Federico Guerrero

International Finance, 2007, vol. 10, issue 2, pages 115-130

Abstract: The Japanese economy experienced a ten-year period of deflation between 1995 and 2005, an experience that has been unprecedented among industrial economies since the Great Depression of the 1930s. This paper offers an equilibrium explanation of deflationary policy rooted in the time-inconsistency literature, and shows that central bank policy may be susceptible to a deflation bias under a set of conditions resembling those actually faced by the Bank of Japan. The paper offers general lessons about central bank policy and provides further support for the adoption of an inflation-targeting framework. Copyright 2007 Blackwell Publishing Ltd.

Date: 2007

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